Why Is My Gas So Cheap?

In May 2008, Goldman Sachs analyst Arjun Murti projected that oil would climb from its then record cost of $129.60/barrel to $200/barrel. The New York Times had Murti predicting that American drivers would soon be facing $6 per gallon gasoline.
Clearly, that didn't happen. Gas is selling for a national average of about $2.80 right now, according to AAA. And since gas prices peaked at $4.11 per gallon in July 2008, there hasn't been much more talk of hundred-dollar fill-ups. Which begs the question, why?

The Basics

Contrary to the view of many Americans, the business of oil is not an American business. As large as ExxonMobil, ConocoPhillips and other American oil companies are, Big Oil is a global business. Because of the size and international scope, neither U.S. companies (nor the U.S. government) controls the world's oil supply. Not by a long shot.

For example, Saudi Aramco is the world's largest oil company when measured by reserves. Other major players include the nationalized oil companies from Iran, China, Venezuela, Iraq, Mexico and other oil producing countries. Russian oil giant OAO Gazprom is one of the world's largest and most profitable oil producers with 2008 profits of $26.7 billion.

Additionally, it's critical to understand that oil flows fairly freely once it's pumped out of the ground, to whomever is willing to pay the most for it. This includes governments, wholesalers, and end-users. Even communist countries play by free-market rules when it comes to oil. So the economics of supply and demand succinctly account for how fuel prices track, much better than your uncle's favorite conspiracy theory.

Slow Economy, Soft Demand, Lower Prices

To find out why Murti and other analysts were wrong when they predicted today's fuel prices, we contacted an independent oil analyst, Patrick DeHann. DeHann is the senior petroleum analyst for GasBuddy.com, an organization that tracks gasoline prices across North America. Providing services through a network of 225 websites to tens of thousands of independent gasoline retailers, DeHann is most definitely not the spokesperson of Big Oil.

Pointing out that the free market largely sets the price, DeHann said that gas prices haven't gone up because the economy has been so bad. And demand is still soft, which is why prices haven't varied much all summer.

"As soon as the banks collapsed in late 2008, the economy slowed. Demand for gas dropped and with it, the price," he said. "A price today of $5 or $6 per gallon wouldn't be feasible," he said. "The market wouldn't support it."

Adding details to DeHann's explanation is John Felmy, the American Petroleum Institute Chief Economist. Felmy represents Big Oil, the same Big Oil that makes sure your corner gas station has fuel to sell you literally 24 hours a day.

"The worldwide economy was still relatively robust in July 2008," he said. "Demand was high, especially from China. They were gearing up for the Olympics, had shut down their coal plants (to reduce air pollution) and were using (cleaner burning) oil for power."

Heavy demand with a tight supply caused an increased price for crude oil. The worldwide price of oil shot up to $147/barrel in July of 2008.Then the financial crisis hit. Demand dropped by several million barrels per day. The barrel price plummeted to $33.

"I look at the situation as purely a function of supply and demand," said Felmy.

Supporting this, DeHann pointed out that toward the end of 2008, American refineries (of which there are approximately 140) were operating at barely 80-percent. During the stronger economic years of 2005-2007, refineries ran at rates of up to 98-percent capacity.

While the economy has recovered some, worldwide demand isn't strong enough to push average gasoline prices in the US past about $2.90 at present.

Calculating The Cost At The Pump

To figure out how much gasoline should cost, Felmy said you should take into account three big categories of variables:

Breaking things down, Felmy noted that a barrel of oil can yield 42 gallons of fuel. His equation divides the cost per barrel, which today is about $81, by 42 to get a rough cost per gallon. He then adds $0.47 (the average of federal and state taxes). Felmy then subtracts that total from the cost of regular gas at the pump. The remaining figure, presently around $0.30, includes the cost of refining, transporting the fuel to and from refineries, marketing costs, and profit.

This addresses the basic question of why gas costs less now than it did in the summer of 2008; the cost for a barrel of oil is $59/barrel less, a $1.40 per gallon reduction.

What's Coming?

GasBuddy.com's DeHann doesn't see gas prices moving too much in the near term. He said, "We see the national average for retail gasoline staying around $2.80 until the economy gets stronger."

All bets are off, however, if there is a major catastrophe or geo-political upheaval.

More Questions

Since we first published "Why Does Gas Cost So Much," we've received plenty of comments from readers. Here are some answers to a few of the most common questions.

Q: Why do prices fluctuate overnight at gas stations?A: About 95 percent of the 170,000 gas stations in the U.S. are independent small businesses. It's likely, then, that your corner gas station is not owned by the company whose fuel they sell. DeHann characterized station owners as little guys fighting to stay in a business that has become exponentially more competitive over the last 20 years.

"These are businesses that struggle for cash flow on a product where there's very little margin," said DeHann.

A tanker of fuel to replenish a station's supply can cost $40,000. To make sure they can afford the next tanker delivery, station owners constantly adjust prices to maximize their profit on the gas they've already purchased. Unlike many other businesses, gasoline is not a "cost-plus" business. The profit margin is constantly being adjusted, hence the price fluctuations.

DeHann explained that if an owner thinks his next tanker might be more expensive because of some reason outside of his control (for instance, oil pipeline failures that have caused havoc in Michigan and Illinois) they will raise prices on gasoline that is already in their tanks.

"Prices are more volatile than they used to be because of all the new trading instruments," said DeHann. He explained that when traders gain knowledge of potential supply issues, this can send price ripples quickly through the system. However, unless the supply problems actually happen, prices settle back down almost as quickly.

Q: Do U.S. currency fluctuations impact fuel prices?A: There is not a simple, one-size-fits-all answer to this question. An important fact is that oil is denominated (meaning priced and traded) in U.S. dollars. Therefore, when the value of the U.S. dollar drops, those buyers who purchase oil using currencies that have gained strength against the dollar get a better deal. This can increase demand, driving prices up.

Q: Does the US government control fuel prices?A: At different times in U.S. history, the government has controlled the price of oil and natural gas. President Nixon's administration was the last to forcibly control the market, resulting in gas shortages. The Reagan administration removed the last remaining price controls in 1981. Outside of the impact of EPA and OHSA regulations, the government doesn't control fuel prices except in times of disaster.

EPA regulations, though, do impact prices. The price hike that comes every year around Memorial Day is directly linked to the dozens of EPA-directed fuel blends that are required to reduce evaporative emissions. The additives used in so-called summer blend gasolines cost more than those used the rest of the year. Refiners can switch back to lower-cost fuel on September 15.

Q: Why Is Big Oil So Greedy?A: There's no doubt that there's big money in oil. The majority of the world's most profitable publicly traded companies deal in oil and natural gas. While it's easy to think that, for instance, ExxonMobil's 2009 profits of $19.3 billion are obscene, like most headlines, there's more to the story.

Economics 101 teaches that there are several ways to look at profits. Most headlines reveal profits are in simple, huge numbers. According to Joseph Trocchio, a financial advisor with Raymond James Financial Services from St. Clair Shores, Michigan, "Another measure is to state profitability as a percentage, showing a company's profit from each dollar of revenue." Trocchio referenced net profit margins of different companies to illustrate the concept. Compared to ExxonMobil's 10.2-percent five-year average net profit margin, Google rakes in 24.7 percent and Apple Computer commands 15 percent. In 2009, ExxonMobil's gross sales were $301.5 billion compared to Google's $23.65 billion and Apple's $42.9 billion.

The API's Felmy added, "Because of the soft economy, in the second quarter of 2010, oil company net profits were just 6.4 percent based on revenue."

Raymond Jame's Trocchio confirmed that this profit level is below the average for the Standard & Poor's 500, which currently averages a net profit around 7 percent.